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What's the Real Risk?

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Which would you choose?

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Prof. Succo,

It seems to me that nearly all of the options selling that you describe is the selling of calls via the buy / write strategy.

If that's the case, isn't the real risk that the market moves much higher than anyone anticipates?

Or are you seeing a lot of put selling too?

Appreciate your insights.

Minyan Jim



MJ-

Let's look at a trade that was done today and then I will let you answer that question.

A dealer out of London bought JP Morgan (JPM) stock at $35.75 and sold the January 2006 calls at $.80. We can assume that they did this to hedge a structured note sold to retail (I have good information on this). We can also assume the dealer wants to make money, so the terms passed through to the investors could not be better than this trade, but to be conservative let's assume that they were the same.

Now let's look at two scenarios: 1) the stock rises 15% (through the strike) to $41, or 2) the stock declines 15% to $31.88 from current prices.

Under scenario 1 the investor's return is: ($.80 (the call premium) + ($37.5 - $35.75) (the capital appreciation in the stock up to the strike) + $.34 (assume one dividend as the second may not be earned as the option may be called)) / ($35.75 - $.80) = 7.3%. The annualized return is 8.2% x 365/184 = 16.4%.

Under this scenario the stock is called away and the investor is left with no position while making a decent return.

Under scenario 2 the investor's return is: ($.8 + ($31.88 - $35.75) + $.34 +.34 (assume both dividends)) / ($35.75 - $.80) = -6.8%. The annualized rate of return is = -13.6%.

Under this scenario the stock remains in the investor's hands.

So which scenario do you think would cause the most consternation? Scenario 1 where the investor has no position left and made a nice return, or scenario 2 where the investor has lost a fair amount and still has risk?

No positions in stocks mentioned.

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